3 Potential Takeover Targets After The CVS-Aetna Merger

News of the Senate vote on tax reform last week buried another headline, one that could be just as momentous in remaking an entire sector of the American economy.

Health insurer Aetna (NYSE: AET ) has agreed to an acquisition by CVS Health (NYSE: CVS ) in a $68 billion deal that could transform the healthcare industry. The addition of Aetna's 22 million insurance customers will create one of the most vertically-integrated behemoths in the industry when added to CVS's nation-wide pharmacy business, pharmaceutical benefits manager (PBM), and retail medical services.

The ability to insure, negotiate drug prices, and deliver health services and pharmaceuticals to customers could create a new standard in healthcare delivery.

This, combined with financial tailwinds from the potential tax reform package, could set off a wave of merger activity in 2018.

And I've found three leaders that could be prime investment targets.

How Could This $68 Billion Mega-Deal Reshape Healthcare?

At $68 billion in cash and stock, the deal is more than twice the size of the next largest M&A deal so far this year. More than the size of the tie-up, the deal could have major significance for the future of healthcare .

After the deal, the combined company would have an unequaled advantage in keeping customers, from diagnosis through drug delivery. The Aetna side of the business will insure customers and can guide them to using CVS services for medical services and pharmaceutical delivery. The PBM will now have even larger customer scale on which to negotiate prices from manufacturers.

The deal still needs approval from regulators, but there are fewer potential objections than the attempted tie-up between Aetna and Humana (NYSE: HUM ), two insurers. While CVS does manage some drug-benefits plans for employers and insurers through its PBM, the merger wouldn't create less competition in one particular segment of the industry like the insurance market.

That scale and control over the health delivery market could drive other companies to vertically integrate others as well.

Not only might the advantages of a CVS-Aetna combination drive other deals but the proposed tax plan in Congress could act as another impetus for a heavy 2018 M&A schedule. Companies could be looking at repatriating billions from overseas, money that will need to be deployed or returned to shareholders. Companies could also take advantage of higher earnings from a lower tax rate to make strategic acquisitions.

This confluence of tailwinds could set off a wave of healthcare mergers in the year to come.

Potential Targets In Healthcare Include PBMs And Pharma Suppliers

CVS is paying approximately $207 per share for Aetna in cash and stock, or 20.3 times the last four quarters' earnings per share. That's a 30% premium to where the shares were trading before rumors of the acquisition broke and signals the interest in the industry for consolidation.

Potential targets after the merger include PBMs , which have been weak this year on headline risks over drug pricing. They have come under fire as part of the problem but are also seen as essential for helping companies negotiate prices for their plans. The PBMs' part in the health care chain is a valuable link and a critical piece for any company seeking vertical integration along the delivery system.

Express Scripts Holding (Nasdaq: ESRX ) has already stated publicly that it would be open to an acquisition. The company is the largest PBM in the United States, with more than 1.4 billion adjusted claims processed annually as well as a strong home delivery pharmaceuticals service.

The three major PBMs, CVS, Express Scripts and UnitedHealth, control nearly 80% of all prescription volume in the United States. CVS is becoming a powerhouse and UnitedHealth would be a tough merger to swallow at $215 billion. That means any company trying to compete in the post-CVS-Aetna world may have no choice but to make an offer for Express Scripts.

Shares are down 1.8% this year and trade for 10 times earnings, less than half the industry average of 21 times trailing earnings. Earnings are expected to be higher by 9% over the next four quarters on a 1.3% increase in revenue.

Another key link in the health care delivery chain is retail pharmaceutical distributors . Pharmacies have been especially strong this year at pressuring suppliers on generic drug pricing, leading to broad losses on shares, but there is evidence that the largest of the discounting is behind us.

Cardinal Health (NYSE: CAH ) is major wholesaler of pharmaceuticals and medical supplies, with operations including nearly everything but manufacturing. The company is the third-largest distributor and counts CVS as its largest customer, meaning it could potentially benefit from higher volume after the CVS-Aetna deal.

Shares are down 21% this year and trade for 11.6 times trailing earnings. The entire industry is down sharply this year and trades for an average 12.5 times trailing earnings. Earnings for Cardinal Health are expected 2.7% lower over the next four quarters, but may surprise higher if drug price discounting slows.

McKesson Corporation (NYSE: MCK ) is the largest wholesale distributor of pharmaceuticals, counting CVS and Walmart as major customers. Along with rivals Cardinal Health and AmerisourceBergen, the three control 90% of the $300 billion retail pharmaceutical distribution market.

Just as with the potential for an Express Scripts acquisition, that industry market control means both McKesson and Cardinal Health could be valuable pieces to any company's strategic plans for vertical M&A next year.

Shares of McKesson are up just 3.5% this year and trade for 12.6 times earnings. Profits are expected higher by 3.1% over the next four quarters to $12.57 per share on an increase of 2.9% in revenue.

Risks To Consider: Shares of healthcare companies could be more volatile than usual on changes to the Affordible Care Act and headline risk on drug pricing over the next few years.

Action To Take: Look into taking a position in these potential takeover targets as the healthcare industry rushes to build vertically-integrated giants to compete with in a post CVS-Aetna industry.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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